Monday, February 16, 2015

Three Tier Tantrums

People love to trash-talk the three-tier system (3TS) that controls alcohol sales in the US. It's a recurring theme in wine writing circles with pretty much everyone saying the same thing ("Death to the 3TS!") And why not? It's a ripe target with plenty to criticize.

The post-Prohibition laws that preserve distributors' margins and prop up an inefficient industry mandate this: retailers can only buy from in-state wholesalers and consumers can only buy from retailers. In a time of overnight delivery and one-click purchasing, the model seems quaint and laughable. Critics of the system complain that the three tier structure is too confining, limiting consumer choice and access to markets for smaller producers. And these are the least of the complaints.

But as valid as those claims are, maybe there's a reason (besides consistent campaign donations to pretty much every state legislator in the country) why the 3TS survives. Maybe, just maybe it's more efficient than we want to give it credit for.

This is a tough subject to write about because to really understand it, you've got to walk down some long corridors lined with economic theory. And who the hell (besides me) likes reading about applied economics? So, in an effort to make the logic more digestible, two graphics embedded below take a swing at explaining the impact of deregulation on the things we care about most: pricing and product selection.

It's tempting to pluck the low hanging fruit of economic theory. If you subscribe to this approach, you probably follow these bread crumbs: Deregulation reduces barriers to entry, and invites competition and innovation. Competition and innovation drive prices down. The lower the barriers to entry, the broader the product selection. And you'd probably stop there because that picture looks awfully appealing.

But the real world isn't quite so tidy. In the first flowchart (click for a larger version), take a look at the impact deregulation would have on prices. In the top left corner, we start with two high-level consequences of deregulation: more competition in the distribution tier and new ways of delivering products to consumers. Under the second branch, there's another triage point: bypassing the distributor versus bypassing both distributor and retailer. Just follow the arrows and you'll get the picture.

The second flow chart is organized the same way, but seeks to answer whether deregulation would result in better product selection.

In both cases, the predicted outcomes seem to contradict the trail of bread crumbs described above. What's more is that they support the idea that the 3TS is already incorporating efficiencies of scale. Take it one step further and one could argue that the margins afforded the three tier supply chain actually support broader product selection than a low margin environment would.

Is there still room for improvement and innovation? Of course. And fat margins inhibit any corporation's incentive to innovate. But things are not quite as dire as the vocal minority would have you believe. As with most inequities, what's probably most appropriate isn't a radical abandonment of 3TS for the sake of consumer-friendliness, but a calibration of what's already working.

Let's say you're a retailer (or a wholesaler) with shelf space for 100 different bottles. Your margin is 30% across the board. You've got a wide diversity of wines at many price points in your portfolio. Due to market changes (i.e. deregulation and increased competition), margins are forced down to 10%. Your operational costs haven't changed, so how are you going to keep the lights on? Simple: you've got to move triple the product. So, what effect is that going to have on the diversity of price points in your portfolio? Well, you know that around 80% of dollar sales of the wine you sell retails for less than $10-12. (Okay, that's an industry average, not what a fine wine retailer in a posh Connecticut shore town would experience, but averages, well, average out.) That means that for every five (it's actually more when calculated by dollars rather than bottles) less expensive bottles you sell, you sell just one north of that price point. While the margin in absolute dollars is higher on those more expensive bottles, the inventory carrying costs are disproportionately higher. You've only got space for 100 different bottles, so it's inevitable that the breadth of your selection will skew to the less expensive, if not shrink entirely.

Your example for argument doesn't work for selection, only pricing. The store still has only room for 100 different bottles (your example's limitation) no matter what, so just because the average price per bottle goes down does not mean less selection. Indeed, in your example, the retailer has to sell 3x more wine to maintain profitability, meaning that the retailer potentially could be tripling his selection over the course of a whole year. So product selection could actually increase.

Deregulation would increase product selection in most markets and profitability for most suppliers. Wineries in states other than CA, WA, OR, and NY would have better access to markets, especially in-state. However, the 3TS is vital to distribution for brands over a certain volume, regardless of regulation; there is no other more efficient system to distribute volume throughout the US. Regulation only truly protects inefficient distributors and the marginal profits made on the few ultra-premium and luxury priced wines distributed by wholesalers.

Thanks for chiming in. In theory your "retailer potentially could potentially be tripling his selection" as a consequence of having to triple volume. I'd like to run this scenario by a few retailers and see if that's what they'd actually do. My guess is that the pressure of having to move more volume would force them to focus more on fast-movers. As one retailer told me a few years back, "If I could just stock Apothic Red, KJ Chard, Troublemaker, and Santa Margherita PG, I would." And that was in a state-mandated 30% market.

As for non-CA, WA, and OR wineries, the size of that market is less than 5% of US demand, so I question the relevance beyond the pain being felt intensely by very few. Still, maybe (as has been the case in NY and parts of MI), if those states made compelling products at reasonable prices consumer demand would drive access to more/better markets.

When people kvetch about the three-tier system, it isn't so much that people want to get rid of it (though some do), but that it shouldn't be mandated by law. It's the smaller wineries that will be better able to distribute their products if they can do so directly. And these are the wineries that the major distributors have little or no interest in and the very wines that aficionados want. The bigger wineries prefer wholesalers. It's more efficient and can sell greater quantities. I don't think prices enter into this too much. Efficiency can and does lower prices. But it's consumer choice that would be enhanced.

Good point, Larry, and I agree that states' legislative prohibition of direct shipments is detrimental to both consumer choice and interstate commerce. But the nine states where direct shipping is prohibited are all in the bottom third in terms of consumption. So, while residents of Utah, for example, are victim to that state's confining direct shipment laws, as 46th state in wine consumption, it's not like wineries are missing out on a huge market. In other words, the pain is felt intensely by very few.

Utah is in a class by itself, as about 60% of the population does not drink mainly for religious reasons. The percentage that does drink buy many wines from nearby states (illegal though it may be). However, even in the more populous states, people's choices are more limited than is apparent. Yes, people can order directly, though even where it is permitted, sometimes there are huge restrictions on which wineries have permits to do so. The cost of shipping is a huge impediment to buying wines from the winery (as is the inconvenience of waiting for it to arrive). If a small winery could ship to a local store, people could pick up their wines as easily as they can buy a Gallo or major Diageo product.

Yes, the cost of shipping is indeed a huge impediment - and cost which would be the same whether shipping to a consumer's door step or to a retailer - so I'm not sure what the advantage would be there. As depicted in the middle vertical of both diagrams above, even if the retailer could buy at a lower cost direct from the producer (which is a big if), their administrative costs skyrocket - something they would not doubt pass along to the consumer. Net-net, it'd be a higher retail price. That said, your point regarding expanding choice is, at least in theory, valid.

Now, one thing absent from all this legislative kvetching is the issue of fees. Even where it is legal to ship direct, many wineries are subject to regulatory import licenses (even if they are going through the 3TS!), which - especially for a smaller winery - can be too high a cost of entry. Which sucks for everyone.

Fair enough, but my original focus was more on selection than on prices. Many factors impact pricing and even two stores near each other can price the same item very differently. And as far as shipping goes, people are more likely to buy a wine if they can get it right now at the posted price. Buying a wine today and putting it immediately on the table or in the fridge is really important to most wine buyers. For all the talk about increasing DTC sales, most wine is not bought that way. If a winery for reasons of cost or paperwork choose to sell solely via wholesalers, that's their right. But to prevent, by law, many direct sales benefits no one except the wholesalers.

Arrgh. Tried to post earlier but Blogger dropped my comments. First, while I'm not sure I agree with the title, I think you are completely correct regarding the fact that 3T will be around for a long time but the the system will definitely be transformed by the internet and consumer pressures. It serves an essential purpose for a key set of accounts, services, and velocity products. That being said the construct is antiquated and outdated resulting in lack of consumer freedom. Regarding your flow charts I think they are a bit one dimensional and do not account for the concept of wines that do not sell out, new product launches, and marketing activities that ALWAYS results in discounts. As such, direct sales from both wineries and retailers will result in lower prices for consumers. - Paul Mabray - VinTank